Inversions: a Symptom of the Tax Code’s Disease
Stopgap efforts to prevent corporate tax inversions won’t fix the underlying problems
With Congress about to return for a final push before the midterm elections in November, one topic on everyone’s lips is so-called corporate inversions. The practice, where a large U.S. company buys a smaller foreign company in order to relocate to avoid paying U.S. corporate taxes, isn’t new, but it is growing. That it has become a problem again is another symptom of our out-of-date tax code.
In the late 1990s and early 2000s, companies relocated to Bermuda and the Cayman Islands, well-known tax havens. In response, Congress passed the American Jobs Creation Act of 2004, which denied tax benefits to the “new” company if it was still owned by 80 percent or more of the former stockholders. In recent years, this threshold and other limits set by Congress have been overtaken by a “second wave” of inversions. Forty-seven corporate inversions have occurred in the last 10 years, with others in the works.
But for all the sound and fury coming from lawmakers and the administration about these “unpatriotic” corporations, it should be no surprise that companies are trying to reduce their taxes. The U.S. tax code, as it is written now, is full of incentives based sometimes on politics and sometimes on policies. It contains loopholes and inefficiencies that create uncertainty, distort decision-making and undercut the ability of the government to collect revenue. Many corporations pay far below the 35 percent statutory corporate tax rate, so while lowering their overall rate of taxation may be one motive for moving abroad, it oversimplifies the phenomenon to assume it is the only motivation.
While U.S. companies pay U.S. tax on foreign earnings, the tax code allows these companies to defer payment of taxes on those earnings until they bring them back to the U.S. U.S. companies have accumulated an estimated $2 trillion in earnings that are indefinitely parked overseas. Some companies likely parked these funds overseas to wait for another repatriation holiday, which allows companies a one-off chance to bring these funds back to the U.S. at a deeply discounted rate. The last repatriation holiday in 2004 allowed foreign earnings to return to the U.S. and be taxed at a rate of 5.25 percent.
But it has been 10 years since that last holiday, so for companies under pressure from shareholders to do something with this money, inverting to Ireland, for example, would allow them to pay out the cash in dividends or invest in U.S. assets without incurring those U.S. taxes. Win for shareholders, but a big loss for the U.S. Treasury.
The U.S. tax code also fails to stop common tax avoidance schemes of foreign-based corporations, another incentive to invert. One scheme, known as “earnings stripping,” involves the foreign parent company lending money to the U.S. affiliate, which then deducts the interest payments it makes to the parent company, “stripping” its taxable U.S. profits. Other schemes involve abuse of transfer pricing, whereby low-tax firms abroad overpay for goods or services from domestic affiliates, shifting overall profits out of the U.S. and into low-tax jurisdictions. Licensing of intellectual property to low-tax jurisdictions is another profit-shifting technique, which helps explain why pharmaceutical companies feature so prominently in recent inversions.
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Congress tried to stop the practice of inversions 10 years ago, but that effort has proven insufficient. Recent proposals from the White House and members of Congress, such as lowering the allowable remaining stockholders in the “new” company from 80 percent to 50 percent, are basically extensions of that original effort. Silver-bullet solutions, like lowering U.S. corporate rates or creating what’s called a territorial system, will not be enough to remove the incentives for U.S. companies to invert.
Many jurisdictions around the world have corporate tax rates far below the target rate of 25 percent being proposed for the U.S. because other countries typically have consumption taxes, like value added taxes, in addition to income taxes. Simply switching to a territorial taxation system, under which only domestic earnings are taxed, without tough anti-avoidance measures isn’t going to stop the practice of stripping U.S.-sourced taxes by foreign parent companies.
Congress and the White House have a bigger problem than corporate inversions – the continuing erosion of confidence in our tax system – and our tax base. Members of both parties should care about the integrity of the U.S. tax system, and the system now is badly broken. Lawmakers can buy themselves some time with measures to prevent the specific kind of inversions going on now, but this is just bailing out water and plugging holes when they need build a new ship. Until Congress addresses the overall need for corporate tax reform, including the underlying incentives to relocate abroad, corporate expatriations will continue in one form or another.
